Can the Leading Economic Index alone predict the future economy? This article explains the concept and uses of this indicator in an easy-to-understand manner. If you want to know how to read economic trends, check it out!
Reading the future economy with the leading economic index
You may have often come across expressions like “The leading economic index is rising, indicating that the economy is expected to improve” and “The leading economic index is falling, indicating that the economy is expected to worsen” in economic news. In this blog post, I will look at the basic concept of the leading economic index used by the government, companies, and the media to predict the economy.
People always want to know the future. I am always curious about what kind of future awaits me, such as when I will find a job, when I will get married, and when I will start making a lot of money. This is probably why people visit fortune-telling shops, psychics, and fortune-telling cafés. Not only individuals are curious about what the future will hold. The same goes for governments and companies. The government and companies need to make more accurate predictions of the future because a wrong decision can lead to a crisis for the country or the company’s collapse. This is why the more advanced a country is, and the more global a company is, the more it invests in future forecasting by creating a separate research organization.
In particular, forecasting the economy is the area where experts put the most effort. This is because the government needs to know in advance how the economy will move in order to prepare various policies and for companies to decide what products to release and when to release them to the market. The Composite Leading Indicator is a data set created by economists and statisticians to predict how the economy will change in the future. For example, in South Korea, the National Statistical Office has been publishing monthly data since March 1983. The Leading Economic Index is, as the name implies, a statistic that precedes the economy. The business cycle can be estimated by the business cycle leading index, which is approximately three to six months in the future. The KSI is calculated based on a value of 100, and higher or lower values are calculated. As with other economic indexes, the higher the number, the more positive the signal.
How is the Leading Economic Index created?
The Leading Economic Index is released every month, so the overall trend is more important than the absolute value. In other words, it is not only important how high it is compared to 100, but it is much more significant whether it is rising compared to the previous month. Even when it comes to economic news, rather than focusing on the numbers themselves, we analyze the overall trend, such as whether it has been rising or falling for several consecutive months.
For your information, the news often uses the expression “cyclical variation of the leading index,” and the government and companies also consider the cyclical variation to be an important statistic. South Korea’s GDP has continued to grow. In Korea, where the economy is developing, GDP is bound to increase even if a recession hits. However, if you look only at the increase in GDP and conclude that there is a recession, you will be in trouble. So, to solve this problem, the cyclical fluctuation rate is a statistical measure that removes the trend, that is, the inertia of economic growth. This will give you a clearer picture of the current economic situation. It is a very complicated concept to get into in detail, so I will only talk about it roughly here.
So how can we predict the economic situation six months in advance? There are eight basic statistics that make up the leading economic index. I will briefly look at some of these statistics and explain why they are used to predict the economy. The first item included in the Leading Economic Index is the ‘job openings-to-applicants ratio’. The job vacancy-to-applicant ratio is the number of people a company is trying to hire (the number of job openings) divided by the number of people looking for a job (the number of job applicants).
The number of job seekers looking for a job is usually constant. However, the number of jobs offered by companies varies greatly depending on the economy. Companies tend to expand their business when they believe that the economy will improve, and on the contrary, they tend to maintain or reduce the scale of their business when they predict that the economy will worsen. At this time, the number of new employees is increased or decreased depending on the situation. The ratio of job offers to job seekers increases as the number of jobs available to people seeking work increases. This statistic shows whether companies are currently trying to expand their business, maintain it, or reduce it. Therefore, the ratio of job offers to job seekers is used as one of the important indicators in the leading economic index.
The KOSPI index, which refers to the stock value of companies listed on the Korea Stock Exchange, is also used to predict the economy. This is because the stock price is more sensitive to future profits, which are expected to be earned by the company than to the profits it is currently earning. A rising KOSPI index means that companies are expected to make more money in the future. On the contrary, the fall in the KOSPI index is also used as a meaningful indicator because it means that companies are expected to earn less profit.
The amount of construction orders won by construction companies is also an important indicator. When construction companies receive a lot of construction orders, they purchase a lot of materials for the construction and hire more workers. Conversely, if the amount of orders decreases, the materials and manpower used in construction will inevitably decrease. The reason why construction orders are used to predict the economy is that the clients who commission the construction tend to build new buildings when the economy is good. To build a building, you need a wide variety of materials, from a small nail to cement, steel bars, glass, finishing materials, and heating and cooling systems. In the case of large construction sites, tens of thousands of workers are often employed for several years. Therefore, the construction industry is considered to be an industry that is greatly affected by the economy.
Other indicators include the inventory turnover ratio, consumer confidence index, machinery export-to-import ratio, import-export price ratio, and the five-year government bond yield. The commonality of the indicators that make up the Leading Economic Index is that they are all figures that help to predict the future in the fields of production, consumption, investment, external economy, employment, and finance. The National Statistical Office will combine the indicators just described to predict whether the economy will improve or worsen in the future. It also talks about the current economic situation at the same time, and this statistic is called the “Business Cycle Index.” It literally means statistics that accompany and move with the game.
While the leading index is composed of items that can predict the future, the coincident index focuses on the present. There is also a statistic called the ‘post-game lag index’, which is a statistic that summarizes the state of the game after a certain period of time has passed. This is a statistic used to check in hindsight how the game has progressed.
So, what is the current state of the Korean economy as seen through the previously explained leading and lagging indexes? The reality of Korea as shown by the statistical indicators is still not optimistic. As of October 2023, the cyclical variation of the 경기동행지수 (K-Composite Business Sentiment Index) fell for five consecutive months, decreasing by 0.1 points from the previous month. This can be seen as a sign that the slowdown in the economy is continuing. The KSI cyclical fluctuation rate was 99.3 as of July 2023, showing an upward trend for two consecutive months, but it still did not exceed 100, leaving uncertainty about the economic recovery.
Meanwhile, according to the November 2022 Leading Economic Index released by the OECD, the index continued to decline in major developed countries such as Germany, France, Italy, the Eurozone as a whole, the UK, Canada, and the US due to high inflation and rising interest rates. On the other hand, Japan is expected to maintain a relatively stable growth trend. Among the non-OECD countries, China showed signs of recovery, driven by increased automobile production and rising stock prices, but India and Brazil were expected to see a slowdown in growth due to a decrease in the money supply and sluggish manufacturing orders, respectively.
These indicators suggest that the economic slowdown will continue for the next six to nine months, so it will be necessary to monitor and respond to them on an ongoing basis.
